The challenge with infrastructure financing is not so much about attracting private capital, but attracting a particular type of private capital. The long-gestation nature of infrastructure assets demands long-term finance.
The specific public policy objective then is, as the Finance Minister said, “to improve access to long-term finance”. This raises the question of what is long-term finance and why is it needed? What type of long-term capital is good for infrastructure? How can long-term finance be mobilised? How much can foreign capital augment domestic savings?
What are the limits to the mobilisation of long-term savings? What are the costs and consequences associated with mobilising long-term finance? In particular, what are the costs associated with the use of public finance? What is the role of public finance in attracting private finance? Let’s briefly examine each in turn.
Long-term finance can be defined as capital which can be committed by its owners for a longer-term. The long gestation period of infrastructure projects necessitates long-term capital to finance them. This can come either from long-term savings or can be created through the process of maturity transformation of shorter-term capital.
Infrastructure assets have very long life spans, which often span several generations. Its benefits are enjoyed by future generations. It makes them amenable to being financed with inter-generational equity. This provides the case for financing them with long-term debt capital.
There are three mechanisms of channelling long-term finance. One, directly by governments which can deploy its resources for the long-term. Another source is that of contracted savings, which are essentially committed savings by employees and others into provident and pension funds, life insurance policies and so on. Finally, banks and other institutions could use various mechanisms to overcome asset-liability mismatches and transform the maturities
of short-term deposits to align with longer-term borrowings.
The conventional wisdom is that such long-term finance can be mobilised through innovative approaches and by efficiency improvements. In other words, the assumption is that financial engineering can help convert capital into long-term finance. While this may be true at the margin, the real aggregate long-term savings available for investments is more or less fixed and limited. In other words, the share of private investors with the risk-returns profile that matches with that of infrastructure sector assets is limited.
The aggregate long-term finance available is a combination of domestic and foreign savings. The former consists of the pool of government, household, and corporate savings which are available for investing.
The domestic savings have to be available in an investible form to be mobilised. However, for a country of its size and stage of development, India is perhaps unique among countries at a similar stage of development in having a very low investible long-term savings share of GDP. In the absence of sufficiently developed channels for financial intermediation and long-term savings, a disproportionately large share of the long-term savings in India is locked up in physical assets like gold and land. This stands in stark contrast to countries like Japan and Singapore, not to mention China, which has successfully mobilised long-term finance.
As regards foreign capital inflows, it is a simple accounting identity that it cannot exceed the sustainable current account deficit. In the circumstances, innovation and efficiency improvements through financial engineering can only take you so far. In other words, there are very clear limits to the total amount of long-term savings that can be mobilised. And we have described the total universe of long-term finance, domestic and foreign, of which
infrastructure is only one of the uses.
There are opportunity costs associated with mobilising long-term finance, public or private, for infrastructure. Clearly governments can raise capital at a cheaper rate than the private sector. But public debt issuance also has the effect of crowding-out private capital raising. However, as long as the marginal cost of public finance is lower than the average total cost of capital, public finance comes with a lower opportunity cost.
Further, with riskier Category III projects, it is not the underlying infrastructure asset that crowds-in private capital, but the deployment of the public investment to finance that infrastructure asset which contributes to the crowding-in.
It is the blending of public finance that makes the capital structure attractive enough for private investors. In other words, public finance plays a concessional role, absorbing some losses in order to make private finance
viable. But this blending introduces an element of non-transparency to the real cost of public finance by obscuring the subsidy incurred. It is therefore important that the true cost of public capital is explicitly recognised and the subsidy called out.
All these will have to be kept in mind while designing any institutional mechanism to improve access to long-term finance.
In the context of any discussions on an institutional mechanism to finance infrastructure, it is pertinent to note that apart from public finance, the major share of infrastructure financing today comes from commercial banks. This poses an asset-liability mismatch problem for banks since a major share of their funds come from shorter-term deposits. Besides banks are not well equipped to diligence and invest in such long-term projects. The other major
potential source of infrastructure finance is the bond market, which for a variety of reasons is very narrow. In the circumstances, specialised DFIs assume significance.
The demand for a new DFI should also be seen against the backdrop of the long-drawn nonperforming assets (NPAs) crisis that has hobbled the country’s banks. The major share of these NPAs has originated in the infrastructure sector. Further, thanks to their predominant role in India’s infrastructure financing boom of the last decade, banks are already close to or at their sectoral exposure limits. This raises questions about sources to fill the financing
In fact, apart from DFIs, on the private sector side, many banks had also opened project finance divisions to fund infrastructure projects. These divisions were at the forefront of the infrastructure project lending boom of 2003-10. As we have seen, this took its toll and form a major share of the banking NPAs. Reflecting the challenges associated with bank financing of infrastructure, in November 2019, ICICI Bank, a pioneer in infrastructure financing,
announced the decision to shut down its project finance division.
Besides this, banks do not have the expertise to make good assessments of such loans, and they also suffer from asset-liability mismatches arising from short-tenor deposit liabilities and long-tenor assets. All this has drawn attention to the pitfalls of using banks to finance longterm infrastructure assets and the value of DFIs.
Gulzar Natarajan is an IAS Officer. Views expressed are personal.
This is the second article in a multi-part article series on infrastructure financing and the challenges associated with the sector. Read the first part here.